As a provider of human resource services for small businesses, Administaff had taken advantage of the strong U.S. economy and launched an aggressive expansion plan since going public in January 1997. Recent economic uncertainty among small business owners, though, left Q4 revenue gains short of projections and Administaff shares hobbled.

While the stock nearly doubled to over $50 a share a year ago, thanks to a ballyhooed co-marketing deal with American Express(NYSE: AXP), it was knocked down to $22 by the market turmoil last fall. Still, by January, the shares had recovered to $34 as the economic fears seemed to have waned following the Federal Reserve's interest rate cuts.

Small business owners, however, didn't get the message. On January 27, Administaff announced that Q4 earnings would be about $0.27 per share, below the consensus estimate of $0.31. The company's core clients were supposedly "reluctant to hire it for payroll services" given economic fears.

So the company experienced lower-than-expected increases in average payroll for worksite employees, which rose 5.5% versus an 8.3% pace in Q3. Also, the average number of worksite employees increased by 29% versus 31% in Q3. This slowdown crimped already thin profit margins because the company has been opening a new office every quarter.

Analysts had been looking for revenue gains in the 35% to 40% range to cover expansion costs. The slowdown clearly sparked fears that the company's entire business model could gradually implode if revenue growth continues to cool. The stock immediately got tripped up for a $15 1/2 loss to $15 3/4.

BUSINESS DESCRIPTION

Administaff is a leading Professional Employer Organization (PEO), basically serving as the human resource department for small- and medium-sized corporations. It recruits workers; oversees payroll and collects payroll taxes; and administers unemployment and workers' compensation insurance programs, 401(k) plans, and health insurance plans.

PEOs promise to free the owners of small businesses (average of 16 employees) from these administrative headaches. Also, economies of scale make various benefit programs more affordable, helping companies offer compensation packages that appeal to employees. Administaff takes over a client's employee base and leases it back for a service fee. It can also generate revenue by getting a share of the cost-savings it can deliver to clients.

The company targets firms with mostly white-collar employees, a population believed to be less susceptible to economic cycles and with less disability exposure.

Administaff has 23 offices nationwide in 14 markets. It plans to enter the New York City market in April, on the way to establishing 90 offices in 40 markets over time. In FY97, Houston and Dallas together accounted for just over half of revenues, down from 80% in FY96.

In February of 1998, American Express paid $17.7 million to acquire 0.7 million shares of Administaff, plus warrants to purchase another 2 million shares at prices between $40 and $80. The deal was part of an arrangement by which AmEx markets the firm's services to its 1.6 million small-business clients and cardholders in exchange for a monthly fee for each client it delivers.

Balance Sheet
Cash: $68.5 million
Current Assets: $104.5 million
Current Liabilities: $50.1 million
Long-Term Debt: N/A

RatiosPrice-to-earnings: 26.5
Price-to-sales: 0.17
EV-to-sales: 0.12

HOW COULD YOU HAVE SEEN IT COMING?

According to the National Association of Professional Employer Organizations, the fragmented PEO industry grew by 30% a year between 1992 and 1998 to $18 billion. Prospects remain wide open since companies like Administaff claim just 2% of the estimated $1.3 trillion paid out in 1997 as wages and benefits to workers at small and midsize businesses.

While Administaff's national expansion strategy is designed to attack this market opportunity, investors had to be concerned about the margin trend. The monthly cost per worksite employee has been growing faster than the revenue per employee. For all of FY97, this cost metric rose by 11.4% while the revenue metric increased by just 10.3%.

This trend continued into FY98. For the first nine months of the year, revenue per employee jumped 8.5%, but costs increased by 9%. In Q3, the revenue metric edged up by just 7.9% while costs shot up 8.3%.

Simply put, operating margins have been declining despite the exceptionally strong revenue gains of 42.6% in the third quarter and 41.4% for the first nine months of 1998. And this despite the supposed marketing efficiencies created by the American Express partnership. A business built on operating efficiency ought to produce rising margins from a increased revenue base, even when it is spending money to grow the business.

Also, while insiders have a massive amount of the stock, and no doubt need to diversify their assets, it's discouraging to see nothing but insider selling, even when the stock dipped last fall.

WHERE TO FROM HERE?

Administaff expects to report $0.62 per share in earnings for FY98, a nickel below the previous consensus. That's up just 5% for the year if you exclude a one-time charge incurred during FY97. Analyst reports are slowly trickling out, but they'll probably project FY99 earnings of about $0.76 to $0.80 per share.

That's at least 22% growth, or well shy of the previous 35% long-term growth estimates. Using a multiple of 25, fair value would be about $20, which is the 12-month target announced by Jefferies & Co. when it upgraded the stock to "accumulate" after the shares slumped. Of course, that firm also said the stock could trade in a $10 to $24 range, no doubt depending on whether Q4 represented just a blip or something worse.

Administaff's board sees a bargain, approving a repurchase of up to a million shares. CFO Richard Rawson noted the firm's belief that "our shares are significantly undervalued relative to our business model and long-term growth prospects."

At the end of December, Administaff had over $70 million in cash and equivalents. There is some seasonality both to the company's earnings and cash holdings. The firm usually reports a Q1 loss due to the effects of employment-related taxes. A year ago, for example, Administaff had $66.6 million in cash, $19.2 million of which was payable in early January for withheld federal and state income taxes, FICA, and other payroll deductions. Still, it's got plenty of cash to fund the buyback.

Another apparent positive is that the co-branded American Express website opened in November and should generate more benefits for Administaff. However, BancBoston Robertson Stephens cut the stock to "market performer" partly because of concerns that Administaff is "targeting too narrow a customer base with a too-high-priced product" and relying too much on the relationship with American Express to "replace its traditional sales channel."

Administaff has an enormous revenue base, but the simple fact is that its net margins are tiny. That's par for the course when gross margins run in the 4% area. While the stock might prove a bargain at the current price, the basic business is simply not that attractive.